Brief commentary on the recent developments, cases, rulings, notices, and related federal tax guidance.

Biden Administration Budget Proposal May Limit Tax-Free Reorganizations for Corporations with Preferred Stock

Recent proposals may limit the ability of corporations to qualify for tax-free treatment. The Biden administration has proposed to amend existing qualification rules to ensure uniformity and prevent gamesmanship, but the proposal may lead to unintended headaches for corporations with preferred stock. If this proposal becomes law, start-up corporations and their investors may consider alternative capital structures and the playbook for planning an acquisition or exit will likely change.

The Biden administration submitted a proposed budget and revenue proposals for the 2023 year, which includes an interesting proposal to align two tax laws governing the relationships between corporations and their shareholders. The reasoning for this proposal is to prevent gamesmanship due to the differences in the existing laws.

The first relationship, testing the element of control, looks at what degree of ownership certain shareholders have in a corporation and is based only on voting power in the corporation. Under this test, ownership of 80 percent of a corporation’s voting stock generally constitutes “control” of the corporation. This test is used for most applications of corporate income tax law, including tax-free mergers and acquisitions.

The second relationship tests the level of affiliation between corporations for purposes of identifying a group of corporations that will file a consolidated tax return. This test looks at the degree of ownership by looking at both voting power and the relative value of the stock. A corporation is “affiliated” with a parent corporation if the parent corporation owns 80 percent of the corporation’s voting stock and holds stock representing 80 percent of the corporation’s value.

Although the budget proposal claims to align these tests, it does not actually reconcile them. Rather, the budget proposal would measure the value of corporate stock on a different basis under the two rules. Specifically, the budget proposal would include the value of certain “pure” preferred stock in the value computation of the control test, while the affiliation test does not include the value of preferred stock. This means that the tests would remain inconsistent, leading to planning opportunities for taxpayers in some cases, and causing some corporations that have raised capital using preferred stock to have fewer options for tax-efficient acquisition or exit strategies in the future.